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Question 44  NPV

The required return of a project is 10%, given as an effective annual rate. Assume that the cash flows shown in the table are paid all at once at the given point in time.

What is the Net Present Value (NPV) of the project?

Project Cash Flows
Time (yrs) Cash flow ($)
0 -100
1 0
2 121
 



Question 250  NPV, Loan, arbitrage table

Your neighbour asks you for a loan of $100 and offers to pay you back $120 in one year.

You don't actually have any money right now, but you can borrow and lend from the bank at a rate of 10% pa. Rates are given as effective annual rates.

Assume that your neighbour will definitely pay you back. Ignore interest tax shields and transaction costs.

The Net Present Value (NPV) of lending to your neighbour is $9.09. Describe what you would do to actually receive a $9.09 cash flow right now with zero net cash flows in the future.



Question 501  NPV, IRR, pay back period

The below graph shows a project's net present value (NPV) against its annual discount rate.

Which of the following statements is NOT correct?



Question 532  mutually exclusive projects, NPV, IRR

An investor owns a whole level of an old office building which is currently worth $1 million. There are three mutually exclusive projects that can be started by the investor. The office building level can be:

  • Rented out to a tenant for one year at $0.1m paid immediately, and then sold for $0.99m in one year.
  • Refurbished into more modern commercial office rooms at a cost of $1m now, and then sold for $2.3m when the refurbishment is finished in one year.
  • Converted into residential apartments at a cost of $2m now, and then sold for $3.4m when the conversion is finished in one year.

All of the development projects have the same risk so the required return of each is 10% pa. The table below shows the estimated cash flows and internal rates of returns (IRR's).

Mutually Exclusive Projects
Project Cash flow
now ($)
Cash flow in
one year ($)
IRR
(% pa)
Rent then sell as is -900,000 990,000 10
Refurbishment into modern offices -2,000,000 2,400,000 20
Conversion into residential apartments -3,000,000 3,400,000 13.33
 

Which project should the investor accept?



Question 353  income and capital returns, inflation, real and nominal returns and cash flows, real estate

A residential investment property has an expected nominal total return of 6% pa and nominal capital return of 3% pa.

Inflation is expected to be 2% pa. All rates are given as effective annual rates.

What are the property's expected real total, capital and income returns? The answer choices below are given in the same order.



Question 407  income and capital returns, inflation, real and nominal returns and cash flows

A stock has a real expected total return of 7% pa and a real expected capital return of 2% pa.

Inflation is expected to be 2% pa. All rates are given as effective annual rates.

What is the nominal expected total return, capital return and dividend yield? The answers below are given in the same order.



Question 531  bankruptcy or insolvency, capital structure, risk, limited liability

Who is most in danger of being personally bankrupt? Assume that all of their businesses' assets are highly liquid and can therefore be sold immediately.



Question 295  inflation, real and nominal returns and cash flows, NPV

When valuing assets using discounted cash flow (net present value) methods, it is important to consider inflation. To properly deal with inflation:

(I) Discount nominal cash flows by nominal discount rates.

(II) Discount nominal cash flows by real discount rates.

(III) Discount real cash flows by nominal discount rates.

(IV) Discount real cash flows by real discount rates.

Which of the above statements is or are correct?



Question 300  NPV, opportunity cost

What is the net present value (NPV) of undertaking a full-time Australian undergraduate business degree as an Australian citizen? Only include the cash flows over the duration of the degree, ignore any benefits or costs of the degree after it's completed.

Assume the following:

  • The degree takes 3 years to complete and all students pass all subjects.
  • There are 2 semesters per year and 4 subjects per semester.
  • University fees per subject per semester are $1,277, paid at the start of each semester. Fees are expected to stay constant for the next 3 years.
  • There are 52 weeks per year.
  • The first semester is just about to start (t=0). The first semester lasts for 19 weeks (t=0 to 19).
  • The second semester starts immediately afterwards (t=19) and lasts for another 19 weeks (t=19 to 38).
  • The summer holidays begin after the second semester ends and last for 14 weeks (t=38 to 52). Then the first semester begins the next year, and so on.
  • Working full time at the grocery store instead of studying full-time pays $20/hr and you can work 35 hours per week. Wages are paid at the end of each week.
  • Full-time students can work full-time during the summer holiday at the grocery store for the same rate of $20/hr for 35 hours per week. Wages are paid at the end of each week.
  • The discount rate is 9.8% pa. All rates and cash flows are real. Inflation is expected to be 3% pa. All rates are effective annual.

The NPV of costs from undertaking the university degree is:



Question 43  pay back period

A project to build a toll road will take 3 years to complete, costing three payments of $50 million, paid at the start of each year (at times 0, 1, and 2).

After completion, the toll road will yield a constant $10 million at the end of each year forever with no costs. So the first payment will be at t=4.

The required return of the project is 10% pa given as an effective nominal rate. All cash flows are nominal.

What is the payback period?



Question 269  time calculation, APR

A student won $1m in a lottery. Currently the money is in a bank account which pays interest at 6% pa, given as an APR compounding per month.

She plans to spend $20,000 at the beginning of every month from now on (so the first withdrawal will be at t=0). After each withdrawal, she will check how much money is left in the account. When there is less than $500,000 left, she will donate that remaining amount to charity.

In how many months will she make her last withdrawal and donate the remainder to charity?



Question 490  expected and historical returns, accounting ratio

Which of the following is NOT a synonym of 'required return'?



Question 404  income and capital returns, real estate

One and a half years ago Frank bought a house for $600,000. Now it's worth only $500,000, based on recent similar sales in the area.

The expected total return on Frank's residential property is 7% pa.

He rents his house out for $1,600 per month, paid in advance. Every 12 months he plans to increase the rental payments.

The present value of 12 months of rental payments is $18,617.27.

The future value of 12 months of rental payments one year in the future is $19,920.48.

What is the expected annual rental yield of the property? Ignore the costs of renting such as maintenance, real estate agent fees and so on.



Question 456  inflation, effective rate

In the 'Austin Powers' series of movies, the character Dr. Evil threatens to destroy the world unless the United Nations pays him a ransom (video 1, video 2). Dr. Evil makes the threat on two separate occasions:

  • In 1969 he demands a ransom of $1 million (=10^6), and again;
  • In 1997 he demands a ransom of $100 billion (=10^11).

If Dr. Evil's demands are equivalent in real terms, in other words $1 million will buy the same basket of goods in 1969 as $100 billion would in 1997, what was the implied inflation rate over the 28 years from 1969 to 1997?

The answer choices below are given as effective annual rates:


Question 234  debt terminology

An 'interest only' loan can also be called a:



Question 373  debt terminology

Which of the following statements is NOT correct? Lenders:



Question 290  APR, effective rate, debt terminology

Which of the below statements about effective rates and annualised percentage rates (APR's) is NOT correct?



Question 26  APR, effective rate

A European bond paying annual coupons of 6% offers a yield of 10% pa.

Convert the yield into an effective monthly rate, an effective annual rate and an effective daily rate. Assume that there are 365 days in a year.

All answers are given in the same order:

### r_\text{eff, monthly} , r_\text{eff, yearly} , r_\text{eff, daily} ###



Question 42  interest only loan

You just signed up for a 30 year interest-only mortgage with monthly payments of $3,000 per month. The interest rate is 6% pa which is not expected to change.

How much did you borrow? After 15 years, just after the 180th payment at that time, how much will be owing on the mortgage? The interest rate is still 6% and is not expected to change. Remember that the mortgage is interest-only and that mortgage payments are paid in arrears (at the end of the month).



Question 57  interest only loan

You just borrowed $400,000 in the form of a 25 year interest-only mortgage with monthly payments of $3,000 per month. The interest rate is 9% pa which is not expected to change.

You actually plan to pay more than the required interest payment. You plan to pay $3,300 in mortgage payments every month, which your mortgage lender allows. These extra payments will reduce the principal and the minimum interest payment required each month.

At the maturity of the mortgage, what will be the principal? That is, after the last (300th) interest payment of $3,300 in 25 years, how much will be owing on the mortgage?



Question 239  income and capital returns, inflation, real and nominal returns and cash flows, interest only loan

A bank grants a borrower an interest-only residential mortgage loan with a very large 50% deposit and a nominal interest rate of 6% that is not expected to change. Assume that inflation is expected to be a constant 2% pa over the life of the loan. Ignore credit risk.

From the bank's point of view, what is the long term expected nominal capital return of the loan asset?



Question 48  IRR, NPV, bond pricing, premium par and discount bonds, market efficiency

The theory of fixed interest bond pricing is an application of the theory of Net Present Value (NPV). Also, a 'fairly priced' asset is not over- or under-priced. Buying or selling a fairly priced asset has an NPV of zero.

Considering this, which of the following statements is NOT correct?



Question 56  income and capital returns, bond pricing, premium par and discount bonds

Which of the following statements about risk free government bonds is NOT correct?

Hint: Total return can be broken into income and capital returns as follows:

###\begin{aligned} r_\text{total} &= \frac{c_1}{p_0} + \frac{p_1-p_0}{p_0} \\ &= r_\text{income} + r_\text{capital} \end{aligned} ###

The capital return is the growth rate of the price.
The income return is the periodic cash flow. For a bond this is the coupon payment.


Question 63  bond pricing, NPV, market efficiency

The theory of fixed interest bond pricing is an application of the theory of Net Present Value (NPV). Also, a 'fairly priced' asset is not over- or under-priced. Buying or selling a fairly priced asset has an NPV of zero.

Considering this, which of the following statements is NOT correct?



Question 153  bond pricing, premium par and discount bonds

Bonds X and Y are issued by different companies, but they both pay a semi-annual coupon of 10% pa and they have the same face value ($100) and maturity (3 years).

The only difference is that bond X and Y's yields are 8 and 12% pa respectively. Which of the following statements is true?



Question 461  book and market values, ROE, ROA, market efficiency

One year ago a pharmaceutical firm floated by selling its 1 million shares for $100 each. Its book and market values of equity were both $100m. Its debt totalled $50m. The required return on the firm's assets was 15%, equity 20% and debt 5% pa.

In the year since then, the firm:

  • Earned net income of $29m.
  • Paid dividends totaling $10m.
  • Discovered a valuable new drug that will lead to a massive 1,000 times increase in the firm's net income in 10 years after the research is commercialised. News of the discovery was publicly announced. The firm's systematic risk remains unchanged.

Which of the following statements is NOT correct? All statements are about current figures, not figures one year ago.

Hint: Book return on assets (ROA) and book return on equity (ROE) are ratios that accountants like to use to measure a business's past performance.

###\text{ROA}= \dfrac{\text{Net income}}{\text{Book value of assets}}###

###\text{ROE}= \dfrac{\text{Net income}}{\text{Book value of equity}}###

The required return on assets ##r_V## is a return that financiers like to use to estimate a business's future required performance which compensates them for the firm's assets' risks. If the business were to achieve realised historical returns equal to its required returns, then investment into the business's assets would have been a zero-NPV decision, which is neither good nor bad but fair.

###r_\text{V, 0 to 1}= \dfrac{\text{Cash flow from assets}_\text{1}}{\text{Market value of assets}_\text{0}} = \dfrac{CFFA_\text{1}}{V_\text{0}}###

Similarly for equity and debt.



Question 499  NPV, Annuity

Some countries' interest rates are so low that they're zero.

If interest rates are 0% pa and are expected to stay at that level for the foreseeable future, what is the most that you would be prepared to pay a bank now if it offered to pay you $10 at the end of every year for the next 5 years?

In other words, what is the present value of five $10 payments at time 1, 2, 3, 4 and 5 if interest rates are 0% pa?



Question 7  DDM

For a price of $1040, Camille will sell you a share which just paid a dividend of $100, and is expected to pay dividends every year forever, growing at a rate of 5% pa.

So the next dividend will be ##100(1+0.05)^1=$105.00##, and the year after it will be ##100(1+0.05)^2=110.25## and so on.

The required return of the stock is 15% pa.

Would you like to the share or politely ?


Question 217  NPV, DDM, multi stage growth model

A stock is expected to pay a dividend of $15 in one year (t=1), then $25 for 9 years after that (payments at t=2 ,3,...10), and on the 11th year (t=11) the dividend will be 2% less than at t=10, and will continue to shrink at the same rate every year after that forever. The required return of the stock is 10%. All rates are effective annual rates.

What is the price of the stock now?



Question 465  NPV, perpetuity

The boss of WorkingForTheManCorp has a wicked (and unethical) idea. He plans to pay his poor workers one week late so that he can get more interest on his cash in the bank.

Every week he is supposed to pay his 1,000 employees $1,000 each. So $1 million is paid to employees every week.

The boss was just about to pay his employees today, until he thought of this idea so he will actually pay them one week (7 days) later for the work they did last week and every week in the future, forever.

Bank interest rates are 10% pa, given as a real effective annual rate. So ##r_\text{eff annual, real} = 0.1## and the real effective weekly rate is therefore ##r_\text{eff weekly, real} = (1+0.1)^{1/52}-1 = 0.001834569##

All rates and cash flows are real, the inflation rate is 3% pa and there are 52 weeks per year. The boss will always pay wages one week late. The business will operate forever with constant real wages and the same number of employees.

What is the net present value (NPV) of the boss's decision to pay later?



Question 50  DDM, stock pricing, inflation, real and nominal returns and cash flows

Most listed Australian companies pay dividends twice per year, the 'interim' and 'final' dividends, which are roughly 6 months apart.

You are an equities analyst trying to value the company BHP. You decide to use the Dividend Discount Model (DDM) as a starting point, so you study BHP's dividend history and you find that BHP tends to pay the same interim and final dividend each year, and that both grow by the same rate.

You expect BHP will pay a $0.55 interim dividend in six months and a $0.55 final dividend in one year. You expect each to grow by 4% next year and forever, so the interim and final dividends next year will be $0.572 each, and so on in perpetuity.

Assume BHP's cost of equity is 8% pa. All rates are quoted as nominal effective rates. The dividends are nominal cash flows and the inflation rate is 2.5% pa.

What is the current price of a BHP share?



Question 733  DDM, income and capital returns

A share’s current price is $60. It’s expected to pay a dividend of $1.50 in one year. The growth rate of the dividend is 0.5% pa and the stock’s required total return is 3% pa. The stock’s price can be modeled using the dividend discount model (DDM):

##P_0=\dfrac{C_1}{r-g}##

Which of the following methods is NOT equal to the stock’s expected price in one year and six months (t=1.5 years)? Note that the symbolic formulas shown in each line below do equal the formulas with numbers. The formula is just repeated with symbols and then numbers in case it helps you to identify the incorrect statement more quickly.



Question 457  PE ratio, Multiples valuation

Which firms tend to have low forward-looking price-earnings (PE) ratios? Only consider firms with positive PE ratios.



Question 503  DDM, NPV, stock pricing

A share currently worth $100 is expected to pay a constant dividend of $4 for the next 5 years with the first dividend in one year (t=1) and the last in 5 years (t=5).

The total required return is 10% pa.

What do you expected the share price to be in 5 years, just after the dividend at that time has been paid?



Question 365  DDM, stock pricing

Stocks in the United States usually pay quarterly dividends. For example, the software giant Microsoft paid a $0.23 dividend every quarter over the 2013 financial year and plans to pay a $0.28 dividend every quarter over the 2014 financial year.

Using the dividend discount model and net present value techniques, calculate the stock price of Microsoft assuming that:

  • The time now is the beginning of July 2014. The next dividend of $0.28 will be received in 3 months (end of September 2014), with another 3 quarterly payments of $0.28 after this (end of December 2014, March 2015 and June 2015).
  • The quarterly dividend will increase by 2.5% every year, but each quarterly dividend over the year will be equal. So each quarterly dividend paid in the financial year beginning in September 2015 will be $ 0.287 ##(=0.28×(1+0.025)^1)##, with the last at the end of June 2016. In the next financial year beginning in September 2016 each quarterly dividend will be $0.294175 ##(=0.28×(1+0.025)^2)##, with the last at the end of June 2017, and so on forever.
  • The total required return on equity is 6% pa.
  • The required return and growth rate are given as effective annual rates.
  • Dividend payment dates and ex-dividend dates are at the same time.
  • Remember that there are 4 quarters in a year and 3 months in a quarter.

What is the current stock price?



Question 534  NPV, no explanation

You have $100,000 in the bank. The bank pays interest at 10% pa, given as an effective annual rate.

You wish to consume half as much now (t=0) as in one year (t=1) and have nothing left in the bank at the end.

How much can you consume at time zero and one? The answer choices are given in the same order.



Question 524  risk, expected and historical returns, bankruptcy or insolvency, capital structure, corporate financial decision theory, limited liability

Which of the following statements is NOT correct?



Question 195  equivalent annual cash flow

An industrial chicken farmer grows chickens for their meat. Chickens:

  1. Cost $0.50 each to buy as chicks. They are bought on the day they’re born, at t=0.
  2. Grow at a rate of $0.70 worth of meat per chicken per week for the first 6 weeks (t=0 to t=6).
  3. Grow at a rate of $0.40 worth of meat per chicken per week for the next 4 weeks (t=6 to t=10) since they’re older and grow more slowly.
  4. Feed costs are $0.30 per chicken per week for their whole life. Chicken feed is bought and fed to the chickens once per week at the beginning of the week. So the first amount of feed bought for a chicken at t=0 costs $0.30, and so on.
  5. Can be slaughtered (killed for their meat) and sold at no cost at the end of the week. The price received for the chicken is their total value of meat (note that the chicken grows fast then slow, see above).

The required return of the chicken farm is 0.5% given as an effective weekly rate.

Ignore taxes and the fixed costs of the factory. Ignore the chicken’s welfare and other environmental and ethical concerns.

Find the equivalent weekly cash flow of slaughtering a chicken at 6 weeks and at 10 weeks so the farmer can figure out the best time to slaughter his chickens. The choices below are given in the same order, 6 and 10 weeks.



Question 462  equivalent annual cash flow

You own some nice shoes which you use once per week on date nights. You bought them 2 years ago for $500. In your experience, shoes used once per week last for 6 years. So you expect yours to last for another 4 years.

Your younger sister said that she wants to borrow your shoes once per week. With the increased use, your shoes will only last for another 2 years rather than 4.

What is the present value of the cost of letting your sister use your current shoes for the next 2 years?

Assume: that bank interest rates are 10% pa, given as an effective annual rate; you will buy a new pair of shoes when your current pair wears out and your sister will not use the new ones; your sister will only use your current shoes so she will only use it for the next 2 years; and the price of new shoes never changes.



Question 207  income and capital returns, bond pricing, coupon rate, no explanation

For a bond that pays fixed semi-annual coupons, how is the annual coupon rate defined, and how is the bond's annual income yield from time 0 to 1 defined mathematically?

Let: ##P_0## be the bond price now,

##F_T## be the bond's face value,

##T## be the bond's maturity in years,

##r_\text{total}## be the bond's total yield,

##r_\text{income}## be the bond's income yield,

##r_\text{capital}## be the bond's capital yield, and

##C_t## be the bond's coupon at time t in years. So ##C_{0.5}## is the coupon in 6 months, ##C_1## is the coupon in 1 year, and so on.



Question 213  income and capital returns, bond pricing, premium par and discount bonds

The coupon rate of a fixed annual-coupon bond is constant (always the same).

What can you say about the income return (##r_\text{income}##) of a fixed annual coupon bond? Remember that:

###r_\text{total} = r_\text{income} + r_\text{capital}###

###r_\text{total, 0 to 1} = \frac{c_1}{p_0} + \frac{p_1-p_0}{p_0}###

Assume that there is no change in the bond's total annual yield to maturity from when it is issued to when it matures.

Select the most correct statement.

From its date of issue until maturity, the income return of a fixed annual coupon:



Question 255  bond pricing

In these tough economic times, central banks around the world have cut interest rates so low that they are practically zero. In some countries, government bond yields are also very close to zero.

A three year government bond with a face value of $100 and a coupon rate of 2% pa paid semi-annually was just issued at a yield of 0%. What is the price of the bond?



Question 616  idiom, debt terminology, bond pricing

"Buy low, sell high" is a phrase commonly heard in financial markets. It states that traders should try to buy assets at low prices and sell at high prices.

Traders in the fixed-coupon bond markets often quote promised bond yields rather than prices. Fixed-coupon bond traders should try to:



Question 173  CFFA

Find Candys Corporation's Cash Flow From Assets (CFFA), also known as Free Cash Flow to the Firm (FCFF), over the year ending 30th June 2013.

Candys Corp
Income Statement for
year ending 30th June 2013
  $m
Sales 200
COGS 50
Operating expense 10
Depreciation 20
Interest expense 10
Income before tax 110
Tax at 30% 33
Net income 77
 
Candys Corp
Balance Sheet
as at 30th June 2013 2012
  $m $m
Assets
Current assets 220 180
PPE    
    Cost 300 340
    Accumul. depr. 60 40
    Carrying amount 240 300
Total assets 460 480
 
Liabilities
Current liabilities 175 190
Non-current liabilities 135 130
Owners' equity
Retained earnings 50 60
Contributed equity 100 100
Total L and OE 460 480
 

 

Note: all figures are given in millions of dollars ($m).



Question 225  CFFA

A firm has forecast its Cash Flow From Assets (CFFA) for this year and management is worried that it is too low. Which one of the following actions will lead to a higher CFFA for this year (t=0 to 1)? Only consider cash flows this year. Do not consider cash flows after one year, or the change in the NPV of the firm. Consider each action in isolation.



Question 351  CFFA

Over the next year, the management of an unlevered company plans to:

  • Achieve firm free cash flow (FFCF or CFFA) of $1m.
  • Pay dividends of $1.8m
  • Complete a $1.3m share buy-back.
  • Spend $0.8m on new buildings without buying or selling any other fixed assets. This capital expenditure is included in the CFFA figure quoted above.

Assume that:

  • All amounts are received and paid at the end of the year so you can ignore the time value of money.
  • The firm has sufficient retained profits to pay the dividend and complete the buy back.
  • The firm plans to run a very tight ship, with no excess cash above operating requirements currently or over the next year.

How much new equity financing will the company need? In other words, what is the value of new shares that will need to be issued?



Question 366  opportunity cost, NPV, CFFA, needs refinement

Your friend is trying to find the net present value of a project. The project is expected to last for just one year with:

  • a negative cash flow of -$1 million initially (t=0), and
  • a positive cash flow of $1.1 million in one year (t=1).

The project has a total required return of 10% pa due to its moderate level of undiversifiable risk.

Your friend is aware of the importance of opportunity costs and the time value of money, but he is unsure of how to find the NPV of the project.

He knows that the opportunity cost of investing the $1m in the project is the expected gain from investing the money in shares instead. Like the project, shares also have an expected return of 10% since they have moderate undiversifiable risk. This opportunity cost is $0.1m ##(=1m \times 10\%)## which occurs in one year (t=1).

He knows that the time value of money should be accounted for, and this can be done by finding the present value of the cash flows in one year.

Your friend has listed a few different ways to find the NPV which are written down below.

(I) ##-1m + \dfrac{1.1m}{(1+0.1)^1} ##

(II) ##-1m + \dfrac{1.1m}{(1+0.1)^1} - \dfrac{1m}{(1+0.1)^1} \times 0.1 ##

(III) ##-1m + \dfrac{1.1m}{(1+0.1)^1} - \dfrac{1.1m}{(1+0.1)^1} \times 0.1 ##

(IV) ##-1m + 1.1m - \dfrac{1.1m}{(1+0.1)^1} \times 0.1 ##

(V) ##-1m + 1.1m - 1.1m \times 0.1 ##

Which of the above calculations give the correct NPV? Select the most correct answer.



Question 486  capital budgeting, opportunity cost, sunk cost

A young lady is trying to decide if she should attend university. Her friends say that she should go to university because she is more likely to meet a clever young man than if she begins full time work straight away.

What's the correct way to classify this item from a capital budgeting perspective when trying to find the Net Present Value of going to university rather than working?

The opportunity to meet a desirable future spouse should be classified as:



Question 511  capital budgeting, CFFA

Find the cash flow from assets (CFFA) of the following project.

One Year Mining Project Data
Project life 1 year
Initial investment in building mine and equipment $9m
Depreciation of mine and equipment over the year $8m
Kilograms of gold mined at end of year 1,000
Sale price per kilogram $0.05m
Variable cost per kilogram $0.03m
Before-tax cost of closing mine at end of year $4m
Tax rate 30%
 

Note 1: Due to the project, the firm also anticipates finding some rare diamonds which will give before-tax revenues of $1m at the end of the year.

Note 2: The land that will be mined actually has thermal springs and a family of koalas that could be sold to an eco-tourist resort for an after-tax amount of $3m right now. However, if the mine goes ahead then this natural beauty will be destroyed.

Note 3: The mining equipment will have a book value of $1m at the end of the year for tax purposes. However, the equipment is expected to fetch $2.5m when it is sold.

Find the project's CFFA at time zero and one. Answers are given in millions of dollars ($m), with the first cash flow at time zero, and the second at time one.



Question 512  capital budgeting, CFFA

Find the cash flow from assets (CFFA) of the following project.

Project Data
Project life 2 years
Initial investment in equipment $6m
Depreciation of equipment per year for tax purposes $1m
Unit sales per year 4m
Sale price per unit $8
Variable cost per unit $3
Fixed costs per year, paid at the end of each year $1.5m
Tax rate 30%
 

Note 1: The equipment will have a book value of $4m at the end of the project for tax purposes. However, the equipment is expected to fetch $0.9 million when it is sold at t=2.

Note 2: Due to the project, the firm will have to purchase $0.8m of inventory initially, which it will sell at t=1. The firm will buy another $0.8m at t=1 and sell it all again at t=2 with zero inventory left. The project will have no effect on the firm's current liabilities.

Find the project's CFFA at time zero, one and two. Answers are given in millions of dollars ($m).



Question 273  CFFA, capital budgeting

Value the following business project to manufacture a new product.

Project Data
Project life 2 yrs
Initial investment in equipment $6m
Depreciation of equipment per year $3m
Expected sale price of equipment at end of project $0.6m
Unit sales per year 4m
Sale price per unit $8
Variable cost per unit $5
Fixed costs per year, paid at the end of each year $1m
Interest expense per year 0
Tax rate 30%
Weighted average cost of capital after tax per annum 10%
 

Notes

  1. The firm's current assets and current liabilities are $3m and $2m respectively right now. This net working capital will not be used in this project, it will be used in other unrelated projects.
    Due to the project, current assets (mostly inventory) will grow by $2m initially (at t = 0), and then by $0.2m at the end of the first year (t=1).
    Current liabilities (mostly trade creditors) will increase by $0.1m at the end of the first year (t=1).
    At the end of the project, the net working capital accumulated due to the project can be sold for the same price that it was bought.
  2. The project cost $0.5m to research which was incurred one year ago.

Assumptions

  • All cash flows occur at the start or end of the year as appropriate, not in the middle or throughout the year.
  • All rates and cash flows are real. The inflation rate is 3% pa.
  • All rates are given as effective annual rates.
  • The business considering the project is run as a 'sole tradership' (run by an individual without a company) and is therefore eligible for a 50% capital gains tax discount when the equipment is sold, as permitted by the Australian Tax Office.

What is the expected net present value (NPV) of the project?



Question 619  CFFA

To value a business's assets, the free cash flow of the firm (FCFF, also called CFFA) needs to be calculated. This requires figures from the firm's income statement and balance sheet. For what figures is the balance sheet needed? Note that the balance sheet is sometimes also called the statement of financial position.



Question 206  CFFA, interest expense, interest tax shield

Interest expense (IntExp) is an important part of a company's income statement (or 'profit and loss' or 'statement of financial performance').

How does an accountant calculate the annual interest expense of a fixed-coupon bond that has a liquid secondary market? Select the most correct answer:

Annual interest expense is equal to:



Question 367  CFFA, interest tax shield

There are many ways to calculate a firm's free cash flow (FFCF), also called cash flow from assets (CFFA). Some include the annual interest tax shield in the cash flow and some do not.

Which of the below FFCF formulas include the interest tax shield in the cash flow?

###(1) \quad FFCF=NI + Depr - CapEx -ΔNWC + IntExp### ###(2) \quad FFCF=NI + Depr - CapEx -ΔNWC + IntExp.(1-t_c)### ###(3) \quad FFCF=EBIT.(1-t_c )+ Depr- CapEx -ΔNWC+IntExp.t_c### ###(4) \quad FFCF=EBIT.(1-t_c) + Depr- CapEx -ΔNWC### ###(5) \quad FFCF=EBITDA.(1-t_c )+Depr.t_c- CapEx -ΔNWC+IntExp.t_c### ###(6) \quad FFCF=EBITDA.(1-t_c )+Depr.t_c- CapEx -ΔNWC### ###(7) \quad FFCF=EBIT-Tax + Depr - CapEx -ΔNWC### ###(8) \quad FFCF=EBIT-Tax + Depr - CapEx -ΔNWC-IntExp.t_c### ###(9) \quad FFCF=EBITDA-Tax - CapEx -ΔNWC### ###(10) \quad FFCF=EBITDA-Tax - CapEx -ΔNWC-IntExp.t_c###

The formulas for net income (NI also called earnings), EBIT and EBITDA are given below. Assume that depreciation and amortisation are both represented by 'Depr' and that 'FC' represents fixed costs such as rent.

###NI=(Rev - COGS - Depr - FC - IntExp).(1-t_c )### ###EBIT=Rev - COGS - FC-Depr### ###EBITDA=Rev - COGS - FC### ###Tax =(Rev - COGS - Depr - FC - IntExp).t_c= \dfrac{NI.t_c}{1-t_c}###



Question 371  interest tax shield, CFFA

One method for calculating a firm's free cash flow (FFCF, or CFFA) is to ignore interest expense. That is, pretend that interest expense ##(IntExp)## is zero:

###\begin{aligned} FFCF &= (Rev - COGS - Depr - FC - IntExp)(1-t_c) + Depr - CapEx -\Delta NWC + IntExp \\ &= (Rev - COGS - Depr - FC - 0)(1-t_c) + Depr - CapEx -\Delta NWC - 0\\ \end{aligned}###
Does this annual FFCF with zero interest expense or the annual interest tax shield?


Question 91  WACC, capital structure

A firm has a debt-to-assets ratio of 50%. The firm then issues a large amount of equity to raise money for new projects of similar systematic risk to the company's existing projects. Assume a classical tax system. Which statement is correct?



Question 99  capital structure, interest tax shield, Miller and Modigliani, trade off theory of capital structure

A firm changes its capital structure by issuing a large amount of debt and using the funds to repurchase shares. Its assets are unchanged.

Assume that:

  • The firm and individual investors can borrow at the same rate and have the same tax rates.
  • The firm's debt and shares are fairly priced and the shares are repurchased at the market price, not at a premium.
  • There are no market frictions relating to debt such as asymmetric information or transaction costs.
  • Shareholders wealth is measured in terms of utiliity. Shareholders are wealth-maximising and risk-averse. They have a preferred level of overall leverage. Before the firm's capital restructure all shareholders were optimally levered.

According to Miller and Modigliani's theory, which statement is correct?



Question 285  covariance, portfolio risk

Two risky stocks A and B comprise an equal-weighted portfolio. The correlation between the stocks' returns is 70%.

If the variance of stock A increases but the:

  • Prices and expected returns of each stock stays the same,
  • Variance of stock B's returns stays the same,
  • Correlation of returns between the stocks stays the same.

Which of the following statements is NOT correct?



Question 563  correlation

What is the correlation of a variable X with itself?

The corr(X, X) or ##\rho_{X,X}## equals:



Question 565  correlation

What is the correlation of a variable X with a constant C?

The corr(X, C) or ##\rho_{X,C}## equals:



Question 306  risk, standard deviation

Let the standard deviation of returns for a share per month be ##\sigma_\text{monthly}##.

What is the formula for the standard deviation of the share's returns per year ##(\sigma_\text{yearly})##?

Assume that returns are independently and identically distributed (iid) so they have zero auto correlation, meaning that if the return was higher than average today, it does not indicate that the return tomorrow will be higher or lower than average.



Question 705  utility, risk aversion, utility function

Mr Blue, Miss Red and Mrs Green are people with different utility functions.

Which of the following statements is NOT correct?

Utility curves



Question 110  CAPM, SML, NPV

The security market line (SML) shows the relationship between beta and expected return.

Investment projects that plot above the SML would have:



Question 628  CAPM, SML, risk, no explanation

Image of CML SML graph

Assets A, B, M and ##r_f## are shown on the graphs above. Asset M is the market portfolio and ##r_f## is the risk free yield on government bonds. Assume that investors can borrow and lend at the risk free rate. Which of the below statements is NOT correct?



Question 673  CAPM, beta, expected and historical returns

A stock has a beta of 1.5. The market's expected total return is 10% pa and the risk free rate is 5% pa, both given as effective annual rates.

In the last 5 minutes, bad economic news was released showing a higher chance of recession. Over this time the share market fell by 1%. The risk free rate was unchanged.

What do you think was the stock's historical return over the last 5 minutes, given as an effective 5 minute rate?



Question 674  CAPM, beta, expected and historical returns

A stock has a beta of 1.5. The market's expected total return is 10% pa and the risk free rate is 5% pa, both given as effective annual rates.

Over the last year, bad economic news was released showing a higher chance of recession. Over this time the share market fell by 1%. The risk free rate was unchanged.

What do you think was the stock's historical return over the last year, given as an effective annual rate?



Question 418  capital budgeting, NPV, interest tax shield, WACC, CFFA, CAPM

Project Data
Project life 1 year
Initial investment in equipment $8m
Depreciation of equipment per year $8m
Expected sale price of equipment at end of project 0
Unit sales per year 4m
Sale price per unit $10
Variable cost per unit $5
Fixed costs per year, paid at the end of each year $2m
Interest expense in first year (at t=1) $0.562m
Corporate tax rate 30%
Government treasury bond yield 5%
Bank loan debt yield 9%
Market portfolio return 10%
Covariance of levered equity returns with market 0.32
Variance of market portfolio returns 0.16
Firm's and project's debt-to-equity ratio 50%
 

Notes

  1. Due to the project, current assets will increase by $6m now (t=0) and fall by $6m at the end (t=1). Current liabilities will not be affected.

Assumptions

  • The debt-to-equity ratio will be kept constant throughout the life of the project. The amount of interest expense at the end of each period has been correctly calculated to maintain this constant debt-to-equity ratio.
  • Millions are represented by 'm'.
  • All cash flows occur at the start or end of the year as appropriate, not in the middle or throughout the year.
  • All rates and cash flows are real. The inflation rate is 2% pa. All rates are given as effective annual rates.
  • The project is undertaken by a firm, not an individual.

What is the net present value (NPV) of the project?



Question 242  technical analysis, market efficiency

Select the most correct statement from the following.

'Chartists', also known as 'technical traders', believe that:



Question 100  market efficiency, technical analysis, joint hypothesis problem

A company selling charting and technical analysis software claims that independent academic studies have shown that its software makes significantly positive abnormal returns. Assuming the claim is true, which statement(s) are correct?

(I) Weak form market efficiency is broken.

(II) Semi-strong form market efficiency is broken.

(III) Strong form market efficiency is broken.

(IV) The asset pricing model used to measure the abnormal returns (such as the CAPM) had mis-specification error so the returns may not be abnormal but rather fair for the level of risk.

Select the most correct response:



Question 105  NPV, risk, market efficiency

A person is thinking about borrowing $100 from the bank at 7% pa and investing it in shares with an expected return of 10% pa. One year later the person will sell the shares and pay back the loan in full. Both the loan and the shares are fairly priced.

What is the Net Present Value (NPV) of this one year investment? Note that you are asked to find the present value (##V_0##), not the value in one year (##V_1##).



Question 338  market efficiency, CAPM, opportunity cost, technical analysis

A man inherits $500,000 worth of shares.

He believes that by learning the secrets of trading, keeping up with the financial news and doing complex trend analysis with charts that he can quit his job and become a self-employed day trader in the equities markets.

What is the expected gain from doing this over the first year? Measure the net gain in wealth received at the end of this first year due to the decision to become a day trader. Assume the following:

  • He earns $60,000 pa in his current job, paid in a lump sum at the end of each year.
  • He enjoys examining share price graphs and day trading just as much as he enjoys his current job.
  • Stock markets are weak form and semi-strong form efficient.
  • He has no inside information.
  • He makes 1 trade every day and there are 250 trading days in the year. Trading costs are $20 per trade. His broker invoices him for the trading costs at the end of the year.
  • The shares that he currently owns and the shares that he intends to trade have the same level of systematic risk as the market portfolio.
  • The market portfolio's expected return is 10% pa.

Measure the net gain over the first year as an expected wealth increase at the end of the year.



Question 417  NPV, market efficiency, DDM

A managed fund charges fees based on the amount of money that you keep with them. The fee is 2% of the end-of-year amount, paid at the end of every year.

This fee is charged regardless of whether the fund makes gains or losses on your money.

The fund offers to invest your money in shares which have an expected return of 10% pa before fees.

You are thinking of investing $100,000 in the fund and keeping it there for 40 years when you plan to retire.

How much money do you expect to have in the fund in 40 years? Also, what is the future value of the fees that the fund expects to earn from you? Give both amounts as future values in 40 years. Assume that:

  • The fund has no private information.
  • Markets are weak and semi-strong form efficient.
  • The fund's transaction costs are negligible.
  • The cost and trouble of investing your money in shares by yourself, without the managed fund, is negligible.
  • The fund invests its fees in the same companies as it invests your funds in, but with no fees.

The below answer choices list your expected wealth in 40 years and then the fund's expected wealth in 40 years.



Question 464  mispriced asset, NPV, DDM, market efficiency

A company advertises an investment costing $1,000 which they say is underpriced. They say that it has an expected total return of 15% pa, but a required return of only 10% pa. Assume that there are no dividend payments so the entire 15% total return is all capital return.

Assuming that the company's statements are correct, what is the NPV of buying the investment if the 15% return lasts for the next 100 years (t=0 to 100), then reverts to 10% pa after that time? Also, what is the NPV of the investment if the 15% return lasts forever?

In both cases, assume that the required return of 10% remains constant. All returns are given as effective annual rates.

The answer choices below are given in the same order (15% for 100 years, and 15% forever):



Question 202  DDM, payout policy

Currently, a mining company has a share price of $6 and pays constant annual dividends of $0.50. The next dividend will be paid in 1 year. Suddenly and unexpectedly the mining company announces that due to higher than expected profits, all of these windfall profits will be paid as a special dividend of $0.30 in 1 year.

If investors believe that the windfall profits and dividend is a one-off event, what will be the new share price? If investors believe that the additional dividend is actually permanent and will continue to be paid, what will be the new share price? Assume that the required return on equity is unchanged. Choose from the following, where the first share price includes the one-off increase in earnings and dividends for the first year only ##(P_\text{0 one-off})## , and the second assumes that the increase is permanent ##(P_\text{0 permanent})##:


Note: When a firm makes excess profits they sometimes pay them out as special dividends. Special dividends are just like ordinary dividends but they are one-off and investors do not expect them to continue, unlike ordinary dividends which are expected to persist.


Question 568  rights issue, capital raising, capital structure

A company conducts a 1 for 5 rights issue at a subscription price of $7 when the pre-announcement stock price was $10. What is the percentage change in the stock price and the number of shares outstanding? The answers are given in the same order. Ignore all taxes, transaction costs and signalling effects.



Question 712  effective rate conversion

An effective monthly return of 1% ##(r_\text{eff monthly})## is equivalent to an effective annual return ##(r_\text{eff annual})## of:



Question 617  systematic and idiosyncratic risk, risk, CAPM

A stock's required total return will increase when its:



Question 622  expected and historical returns, risk

An economy has only two investable assets: stocks and cash.

Stocks had a historical nominal average total return of negative two percent per annum (-2% pa) over the last 20 years. Stocks are liquid and actively traded. Stock returns are variable, they have risk.

Cash is riskless and has a nominal constant return of zero percent per annum (0% pa), which it had in the past and will have in the future. Cash can be kept safely at zero cost. Cash can be converted into shares and vice versa at zero cost.

The nominal total return of the shares over the next year is expected to be:



Question 626  cross currency interest rate parity, foreign exchange rate, forward foreign exchange rate

The Australian cash rate is expected to be 2% pa over the next one year, while the Japanese cash rate is expected to be 0% pa, both given as nominal effective annual rates. The current exchange rate is 100 JPY per AUD.

What is the implied 1 year forward foreign exchange rate?



Question 630  mispriced asset, NPV, DDM, market efficiency

A company advertises an investment costing $1,000 which they say is underpriced. They say that it has an expected total return of 15% pa, but a required return of only 10% pa. Of the 15% pa total expected return, the dividend yield is expected to always be 7% pa and rest is the capital yield.

Assuming that the company's statements are correct, what is the NPV of buying the investment if the 15% total return lasts for the next 100 years (t=0 to 100), then reverts to 10% after that time? Also, what is the NPV of the investment if the 15% return lasts forever?

In both cases, assume that the required return of 10% remains constant, the dividends can only be re-invested at 10% pa and all returns are given as effective annual rates.

The answer choices below are given in the same order (15% for 100 years, and 15% forever):



Question 655  capital budgeting, opportunity cost, sunk cost

The 'time value of money' is most closely related to which of the following concepts?



Question 660  fully amortising loan, interest only loan, APR

How much more can you borrow using an interest-only loan compared to a 25-year fully amortising loan if interest rates are 6% pa compounding per month and are not expected to change? If it makes it easier, assume that you can afford to pay $2,000 per month on either loan. Express your answer as a proportional increase using the following formula:

###\text{Proportional Increase} = \dfrac{V_\text{0,interest only}}{V_\text{0,fully amortising}} - 1###



Question 668  buy and hold, market efficiency, idiom

A quote from the famous investor Warren Buffet: "Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell."

Buffet is referring to the buy-and-hold strategy which is to buy and never sell shares. Which of the following is a disadvantage of a buy-and-hold strategy? Assume that share markets are semi-strong form efficient. Which of the following is NOT an advantage of the strict buy-and-hold strategy? A disadvantage of the buy-and-hold strategy is that it reduces:



Question 735  debt terminology

You deposit money into a bank. Which of the following statements is NOT correct? You:



Question 749  Multiples valuation, PE ratio, NPV

A real estate agent says that the price of a house in Sydney Australia is approximately equal to the gross weekly rent times 1000.

What type of valuation method is the real estate agent using?



Question 750  PE ratio, Multiples valuation

Itau Unibanco is a major listed bank in Brazil with a market capitalisation of equity equal to BRL 85.744 billion, EPS of BRL 3.96 and 2.97 billion shares on issue.

Banco Bradesco is another major bank with total earnings of BRL 8.77 billion and 2.52 billion shares on issue.

Estimate Banco Bradesco's current share price using a price-earnings multiples approach assuming that Itau Unibanco is a comparable firm.

Note that BRL is the Brazilian Real, their currency. Figures sourced from Google Finance on the market close of the BVMF on 24/7/15.



Question 754  fully amortising loan, interest only loan

How much more can you borrow using an interest-only loan compared to a 25-year fully amortising loan if interest rates are 4% pa compounding per month and are not expected to change? If it makes it easier, assume that you can afford to pay $2,000 per month on either loan. Express your answer as a proportional increase using the following formula:

###\text{Proportional Increase} = \dfrac{V_\text{0,interest only}}{V_\text{0,fully amortising}} - 1###



Question 282  expected and historical returns, income and capital returns

You're the boss of an investment bank's equities research team. Your five analysts are each trying to find the expected total return over the next year of shares in a mining company. The mining firm:

  • Is regarded as a mature company since it's quite stable in size and was floated around 30 years ago. It is not a high-growth company;
  • Share price is very sensitive to changes in the price of the market portfolio, economic growth, the exchange rate and commodities prices. Due to this, its standard deviation of total returns is much higher than that of the market index;
  • Experienced tough times in the last 10 years due to unexpected falls in commodity prices.
  • Shares are traded in an active liquid market.
Your team of analysts present their findings, and everyone has different views. While there's no definitive true answer, who's calculation of the expected total return is the most plausible?

Assume that:

  • The analysts' source data is correct and true, but their inferences might be wrong;
  • All returns and yields are given as effective annual nominal rates.



Question 562  covariance

What is the covariance of a variable X with itself?

The cov(X, X) or ##\sigma_{X,X}## equals:



Question 560  standard deviation, variance

The standard deviation and variance of a stock's annual returns are calculated over a number of years. The units of the returns are percent per annum ##(\% pa)##.

What are the units of the standard deviation ##(\sigma)## and variance ##(\sigma^2)## of returns respectively?

Hint: Visit Wikipedia to understand the difference between percentage points ##(\text{pp})## and percent ##(\%)##.


Question 697  utility, risk aversion, utility function

Mr Blue, Miss Red and Mrs Green are people with different utility functions. Which of the statements about the 3 utility functions is NOT correct?

Utility curves



Question 702  utility, risk aversion, utility function, gamble

Mr Blue, Miss Red and Mrs Green are people with different utility functions.

Each person has $50 of initial wealth. A coin toss game is offered to each person at a casino where the player can win or lose $50. Each player can flip a coin and if they flip heads, they receive $50. If they flip tails then they will lose $50. Which of the following statements is NOT correct?

Utility curves



Question 248  CAPM, DDM, income and capital returns

The total return of any asset can be broken down in different ways. One possible way is to use the dividend discount model (or Gordon growth model):

###p_0 = \frac{c_1}{r_\text{total}-r_\text{capital}}###

Which, since ##c_1/p_0## is the income return (##r_\text{income}##), can be expressed as:

###r_\text{total}=r_\text{income}+r_\text{capital}###

So the total return of an asset is the income component plus the capital or price growth component.

Another way to break up total return is to use the Capital Asset Pricing Model:

###r_\text{total}=r_\text{f}+β(r_\text{m}- r_\text{f})###

###r_\text{total}=r_\text{time value}+r_\text{risk premium}###

So the risk free rate is the time value of money and the term ##β(r_\text{m}- r_\text{f})## is the compensation for taking on systematic risk.

Using the above theory and your general knowledge, which of the below equations, if any, are correct?

(I) ##r_\text{income}=r_\text{time value}##

(II) ##r_\text{income}=r_\text{risk premium}##

(III) ##r_\text{capital}=r_\text{time value}##

(IV) ##r_\text{capital}=r_\text{risk premium}##

(V) ##r_\text{income}+r_\text{capital}=r_\text{time value}+r_\text{risk premium}##

Which of the equations are correct?



Question 117  WACC

A firm can issue 5 year annual coupon bonds at a yield of 8% pa and a coupon rate of 12% pa.

The beta of its levered equity is 1. Five year government bonds yield 5% pa with a coupon rate of 6% pa. The market's expected dividend return is 4% pa and its expected capital return is 6% pa.

The firm's debt-to-equity ratio is 2:1. The corporate tax rate is 30%.

What is the firm's after-tax WACC? Assume a classical tax system.



Question 494  franking credit, personal tax on dividends, imputation tax system

A firm pays a fully franked cash dividend of $100 to one of its Australian shareholders who has a personal marginal tax rate of 15%. The corporate tax rate is 30%.

What will be the shareholder's personal tax payable due to the dividend payment?



Question 455  income and capital returns, payout policy, DDM, market efficiency

A fairly priced unlevered firm plans to pay a dividend of $1 next year (t=1) which is expected to grow by 3% pa every year after that. The firm's required return on equity is 8% pa.

The firm is thinking about reducing its future dividend payments by 10% so that it can use the extra cash to invest in more projects which are expected to return 8% pa, and have the same risk as the existing projects. Therefore, next year's dividend will be $0.90.

What will be the stock's new annual capital return (proportional increase in price per year) if the change in payout policy goes ahead?

Assume that payout policy is irrelevant to firm value and that all rates are effective annual rates.



Question 772  interest tax shield, capital structure, leverage, no explanation

A firm issues debt and uses the funds to buy back equity. Assume that there are no costs of financial distress or transactions costs. Which of the following statements about interest tax shields is NOT correct?



Question 780  mispriced asset, NPV, DDM, market efficiency, no explanation

A company advertises an investment costing $1,000 which they say is under priced. They say that it has an expected total return of 15% pa, but a required return of only 10% pa. Of the 15% pa total expected return, the dividend yield is expected to be 4% pa and the capital yield 11% pa. Assume that the company's statements are correct.

What is the NPV of buying the investment if the 15% total return lasts for the next 100 years (t=0 to 100), then reverts to 10% after that time? Also, what is the NPV of the investment if the 15% return lasts forever?

In both cases, assume that the required return of 10% remains constant, the dividends can only be re-invested at 10% pa and all returns are given as effective annual rates. The answer choices below are given in the same order (15% for 100 years, and 15% forever):



Question 205  depreciation tax shield, CFFA

There are a number of ways that assets can be depreciated. Generally the government's tax office stipulates a certain method.

But if it didn't, what would be the ideal way to depreciate an asset from the perspective of a businesses owner?



Question 343  CFFA, capital budgeting

An old company's Firm Free Cash Flow (FFCF, same as CFFA) is forecast in the graph below.

Image of option graphs

To value the firm's assets, the terminal value needs to be calculated using the perpetuity with growth formula:

###V_{\text{terminal, }t-1} = \dfrac{FFCF_{\text{terminal, }t}}{r-g}###

Which point corresponds to the best time to calculate the terminal value?



Question 344  CFFA, capital budgeting

A new company's Firm Free Cash Flow (FFCF, same as CFFA) is forecast in the graph below.

Image of option graphs

To value the firm's assets, the terminal value needs to be calculated using the perpetuity with growth formula:

###V_{\text{terminal, }t-1} = \dfrac{FFCF_{\text{terminal, }t}}{r-g}###

Which point corresponds to the best time to calculate the terminal value?



Question 6  DDM

For a price of $102, Andrea will sell you a share which just paid a dividend of $10 yesterday, and is expected to pay dividends every year forever, growing at a rate of 5% pa.

So the next dividend will be ##10(1+0.05)^1=$10.50## in one year from now, and the year after it will be ##10(1+0.05)^2=11.025## and so on.

The required return of the stock is 15% pa.

Would you like to the share or politely ?


Question 20  NPV, APR, Annuity

Your friend wants to borrow $1,000 and offers to pay you back $100 in 6 months, with more $100 payments at the end of every month for another 11 months. So there will be twelve $100 payments in total. She says that 12 payments of $100 equals $1,200 so she's being generous.

If interest rates are 12% pa, given as an APR compounding monthly, what is the Net Present Value (NPV) of your friend's deal?



Question 22  NPV, perpetuity with growth, effective rate, effective rate conversion

What is the NPV of the following series of cash flows when the discount rate is 10% given as an effective annual rate?

The first payment of $90 is in 3 years, followed by payments every 6 months in perpetuity after that which shrink by 3% every 6 months. That is, the growth rate every 6 months is actually negative 3%, given as an effective 6 month rate. So the payment at ## t=3.5 ## years will be ## 90(1-0.03)^1=87.3 ##, and so on.



Question 74  WACC, capital structure, CAPM

A firm's weighted average cost of capital before tax (##r_\text{WACC before tax}##) would increase due to:



Question 75  WACC, CAPM

A company has:

  • 50 million shares outstanding.
  • The market price of one share is currently $6.
  • The risk-free rate is 5% and the market return is 10%.
  • Market analysts believe that the company's ordinary shares have a beta of 2.
  • The company has 1 million preferred stock which have a face (or par) value of $100 and pay a constant dividend of 10% of par. They currently trade for $80 each.
  • The company's debentures are publicly traded and their market price is equal to 90% of their face value.
  • The debentures have a total face value of $60,000,000 and the current yield to maturity of corporate debentures is 10% per annum. The corporate tax rate is 30%.

What is the company's after-tax weighted average cost of capital (WACC)? Assume a classical tax system.



Question 104  CAPM, payout policy, capital structure, Miller and Modigliani, risk

Assume that there exists a perfect world with no transaction costs, no asymmetric information, no taxes, no agency costs, equal borrowing rates for corporations and individual investors, the ability to short the risk free asset, semi-strong form efficient markets, the CAPM holds, investors are rational and risk-averse and there are no other market frictions.

For a firm operating in this perfect world, which statement(s) are correct?

(i) When a firm changes its capital structure and/or payout policy, share holders' wealth is unaffected.

(ii) When the idiosyncratic risk of a firm's assets increases, share holders do not expect higher returns.

(iii) When the systematic risk of a firm's assets increases, share holders do not expect higher returns.

Select the most correct response:



Question 271  CAPM, option, risk, systematic risk, systematic and idiosyncratic risk

All things remaining equal, according to the capital asset pricing model, if the systematic variance of an asset increases, its required return will increase and its price will decrease.
If the idiosyncratic variance of an asset increases, its price will be unchanged.

What is the relationship between the price of a call or put option and the total, systematic and idiosyncratic variance of the underlying asset that the option is based on? Select the most correct answer.

Call and put option prices increase when the:



Question 450  CAPM, risk, portfolio risk, no explanation

The accounting identity states that the book value of a company's assets (A) equals its liabilities (L) plus owners equity (OE), so A = L + OE.

The finance version states that the market value of a company's assets (V) equals the market value of its debt (D) plus equity (E), so V = D + E.

Therefore a business's assets can be seen as a portfolio of the debt and equity that fund the assets.

Let ##\sigma_\text{V total}^2## be the total variance of returns on assets, ##\sigma_\text{V syst}^2## be the systematic variance of returns on assets, and ##\sigma_\text{V idio}^2## be the idiosyncratic variance of returns on assets, and ##\rho_\text{D idio, E idio}## be the correlation between the idiosyncratic returns on debt and equity.

Which of the following equations is NOT correct?



Question 237  WACC, Miller and Modigliani, interest tax shield

Which of the following discount rates should be the highest for a levered company? Ignore the costs of financial distress.



Question 376  leverage, capital structure, no explanation

Interest expense on debt is tax-deductible, but dividend payments on equity are not. or ?


Question 380  leverage, capital structure

The "interest expense" on a company's annual income statement is equal to the cash interest payments (but not principal payments) made to debt holders during the year. or ?


Question 397  financial distress, leverage, capital structure, NPV

A levered firm has a market value of assets of $10m. Its debt is all comprised of zero-coupon bonds which mature in one year and have a combined face value of $9.9m.

Investors are risk-neutral and therefore all debt and equity holders demand the same required return of 10% pa.

Therefore the current market capitalisation of debt ##(D_0)## is $9m and equity ##(E_0)## is $1m.

A new project presents itself which requires an investment of $2m and will provide a:

  • $6.6m cash flow with probability 0.5 in the good state of the world, and a
  • -$4.4m (notice the negative sign) cash flow with probability 0.5 in the bad state of the world.

The project can be funded using the company's excess cash, no debt or equity raisings are required.

What would be the new market capitalisation of equity ##(E_\text{0, with project})## if shareholders vote to proceed with the project, and therefore should shareholders proceed with the project?



Question 398  financial distress, capital raising, leverage, capital structure, NPV

A levered firm has zero-coupon bonds which mature in one year and have a combined face value of $9.9m.

Investors are risk-neutral and therefore all debt and equity holders demand the same required return of 10% pa.

In one year the firm's assets will be worth:

  • $13.2m with probability 0.5 in the good state of the world, or
  • $6.6m with probability 0.5 in the bad state of the world.

A new project presents itself which requires an investment of $2m and will provide a certain cash flow of $3.3m in one year.

The firm doesn't have any excess cash to make the initial $2m investment, but the funds can be raised from shareholders through a fairly priced rights issue. Ignore all transaction costs.

Should shareholders vote to proceed with the project and equity raising? What will be the gain in shareholder wealth if they decide to proceed?



Question 458  capital budgeting, no explanation

Which of the following is NOT a valid method to estimate future revenues or costs in a pro-forma income statement when trying to value a company?



Question 487  capital budgeting, opportunity cost, sunk cost

A young lady is trying to decide if she should attend university or begin working straight away in her home town.

The young lady's grandma says that she should not go to university because she is less likely to marry the local village boy whom she likes because she will spend less time with him if she attends university.

What's the correct way to classify this item from a capital budgeting perspective when trying to decide whether to attend university?

The cost of not marrying the local village boy should be classified as:



Question 228  DDM, NPV, risk, market efficiency

A very low-risk stock just paid its semi-annual dividend of $0.14, as it has for the last 5 years. You conservatively estimate that from now on the dividend will fall at a rate of 1% every 6 months.

If the stock currently sells for $3 per share, what must be its required total return as an effective annual rate?

If risk free government bonds are trading at a yield of 4% pa, given as an effective annual rate, would you consider buying or selling the stock?

The stock's required total return is:



Question 308  risk, standard deviation, variance, no explanation

A stock's standard deviation of returns is expected to be:

  • 0.09 per month for the first 5 months;
  • 0.14 per month for the next 7 months.

What is the expected standard deviation of the stock per year ##(\sigma_\text{annual})##?

Assume that returns are independently and identically distributed (iid) and therefore have zero auto-correlation.



Question 471  risk, accounting ratio

High risk firms in danger of bankruptcy tend to have:



Question 253  NPV, APR

You just started work at your new job which pays $48,000 per year.

The human resources department have given you the option of being paid at the end of every week or every month.

Assume that there are 4 weeks per month, 12 months per year and 48 weeks per year.

Bank interest rates are 12% pa given as an APR compounding per month.

What is the dollar gain over one year, as a net present value, of being paid every week rather than every month?



Question 256  APR, effective rate

A 2 year corporate bond yields 3% pa with a coupon rate of 5% pa, paid semi-annually.

Find the effective monthly rate, effective six month rate, and effective annual rate.

##r_\text{eff monthly}##, ##r_\text{eff 6 month}##, ##r_\text{eff annual}##.



Question 108  bond pricing, zero coupon bond, term structure of interest rates, forward interest rate

An Australian company just issued two bonds:

  • A 1 year zero coupon bond at a yield of 10% pa, and
  • A 2 year zero coupon bond at a yield of 8% pa.

What is the forward rate on the company's debt from years 1 to 2? Give your answer as an APR compounding every 6 months, which is how the above bond yields are quoted.



Question 539  debt terminology, fully amortising loan, bond pricing

A 'fully amortising' loan can also be called a:



Question 514  corporate financial decision theory, idiom

The expression 'cash is king' emphasizes the importance of which business decision?



Question 54  NPV, DDM

A stock is expected to pay the following dividends:

Cash Flows of a Stock
Time (yrs) 0 1 2 3 4 ...
Dividend ($) 0.00 1.15 1.10 1.05 1.00 ...
 

After year 4, the annual dividend will grow in perpetuity at -5% pa. Note that this is a negative growth rate, so the dividend will actually shrink. So,

  • the dividend at t=5 will be ##$1(1-0.05) = $0.95##,
  • the dividend at t=6 will be ##$1(1-0.05)^2 = $0.9025##, and so on.

The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates.

What is the current price of the stock?



Question 241  Miller and Modigliani, leverage, payout policy, diversification, NPV

One of Miller and Modigliani's (M&M's) important insights is that a firm's managers should not try to achieve a particular level of leverage or interest tax shields under certain assumptions. So the firm's capital structure is irrelevant. This is because investors can make their own personal leverage and interest tax shields, so there's no need for managers to try to make corporate leverage and interest tax shields. This is true under the assumptions of equal tax rates, interest rates and debt availability for the person and the corporation, no transaction costs and symmetric information.

This principal of 'home-made' or 'do-it-yourself' leverage can also be applied to other topics. Read the following statements to decide which are true:

(I) Payout policy: a firm's managers should not try to achieve a particular pattern of equity payout.

(II) Agency costs: a firm's managers should not try to minimise agency costs.

(III) Diversification: a firm's managers should not try to diversify across industries.

(IV) Shareholder wealth: a firm's managers should not try to maximise shareholders' wealth.

Which of the above statement(s) are true?



Question 475  payout ratio, dividend, no explanation

The below screenshot of Commonwealth Bank of Australia's (CBA) details were taken from the Google Finance website on 7 Nov 2014. Some information has been deliberately blanked out.

Image of CBA on Google finance on 7 Nov 2014

What was CBA's approximate payout ratio over the 2014 financial year?

Note that the firm's interim and final dividends were $1.83 and $2.18 respectively over the 2014 financial year.



Question 402  PE ratio, no explanation

Which of the following companies is most suitable for valuation using PE multiples techniques?



Question 403  PE ratio, no explanation

Which of the following investable assets is the LEAST suitable for valuation using PE multiples techniques?



Question 493  PE ratio

A firm has 2m shares and a market capitalisation of equity of $30m. The firm just announced earnings of $5m and paid an annual dividend of $0.75 per share.

What is the firm's (backward looking) price/earnings (PE) ratio?



Question 809  Markowitz portfolio theory, CAPM, Jensens alpha, CML, systematic and idiosyncratic risk

A graph of assets’ expected returns ##(\mu)## versus standard deviations ##(\sigma)## is given in the graph below. The CML is the capital market line.

Image of CML graph

Which of the following statements about this graph, Markowitz portfolio theory and the Capital Asset Pricing Model (CAPM) theory is NOT correct?



Question 599  bond pricing

On 22-Mar-2013 the Australian Government issued series TB139 treasury bonds with a combined face value $23.4m, listed on the ASX with ticker code GSBG25.

The bonds mature on 21-Apr-2025, the fixed coupon rate is 3.25% pa and coupons are paid semi-annually on the 21st of April and October of each year. Each bond's face value is $1,000.

At market close on Friday 11-Sep-2015 the bonds' yield was 2.736% pa.

At market close on Monday 14-Sep-2015 the bonds' yield was 2.701% pa. Both yields are given as annualised percentage rates (APR's) compounding every 6 months. For convenience, assume 183 days in 6 months and 366 days in a year.

What was the historical total return over those 3 calendar days between Friday 11-Sep-2015 and Monday 14-Sep-2015?

There are 183 calendar days from market close on the last coupon 21-Apr-2015 to the market close of the next coupon date on 21-Oct-2015.

Between the market close times from 21-Apr-2015 to 11-Sep-2015 there are 143 calendar days. From 21-Apr-2015 to 14-Sep-2015 there are 146 calendar days.

From 14-Sep-2015 there were 20 coupons remaining to be paid including the next one on 21-Oct-2015.

All of the below answers are given as effective 3 day rates.



Question 791  mean and median returns, return distribution, arithmetic and geometric averages, continuously compounding rate, log-normal distribution, VaR, confidence interval

A risk manager has identified that their pension fund’s continuously compounded portfolio returns are normally distributed with a mean of 5% pa and a standard deviation of 20% pa. The fund’s portfolio is currently valued at $1 million. Assume that there is no estimation error in the above figures. To simplify your calculations, all answers below use 2.33 as an approximation for the normal inverse cumulative density function at 99%. All answers are rounded to the nearest dollar. Which of the following statements is NOT correct?



Question 873  Sharpe ratio, Treynor ratio, Jensens alpha, SML, CAPM

Which of the following statements is NOT correct? Fairly-priced assets should:



Question 874  arithmetic and geometric averages

Who was the first theorist to endorse the maximisiation of the geometric average gross discrete return for investors (not gamblers) since it gave a "...portfolio that has a greater probability of being as valuable or more valuable than any other significantly different portfolio at the end of n years, n being large"?

(a) Daniel Bernoulli.




Copyright © 2014 Keith Woodward